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Why a Market Correction Now Would be the Best Scenario.

Nobel Laureate in economics Jeremy Siegel says he is still not concerned with valuations and has upped his previous projection of 18,000 for the Dow by year-end to “possibly 19,000”.

However, Nobel Laureate in economics Robert Shiller is very worried, noting that the market is 65% overvalued based on the Shiller CAPE10 P/E ratio, the market’s main fuel now being “irrational exuberance”.

Newsletter writers and retail investors are very bullish, while corporate insiders and famous billionaire investors are increasingly pessimistic.

For instance, George Soros has significantly increased his positions in put option bets against the S&P 500, while Warren Buffett is holding a record amount of cash.

Billionaire investor Sam Zell says, “Something has to give here. The stock market is at an all-time high, and economic activity is not.”

Jim Paulsen of Wells Capital Management, one of the biggest bulls during the last five years, is now telling clients to “shift out of U.S. stocks and into international markets.”

They are not only concerned about the high market valuation and age of the bull market. They speak of how the extremely aggressive actions of the Fed over the last five years resulted in only an anemic economic recovery. Yet the market, always looking ahead, will soon have to begin anticipating those actions being reversed; the unloading of the unprecedented $4 trillion in mortgage-back securities and U.S. Treasury bonds on the Fed’s balance sheet, raising the record low interest rates back to normal, and so on.

Their concerns are well-founded.

However, if we could get a normal (and overdue) 15% to 20% correction now, to cool off stock valuations and investor euphoria, the next bear market – and yes there is always a next bear market – could be postponed for several years.

The worst scenario would be if we do not get a normal correction now, allowing the excesses the ‘smart money’ is worried about to become even more extreme.

History also chimes in with a warning about the danger of not having a correction now, that warning coming from the Four-Year Presidential Cycle.

Most investors are aware of the cycle’s basic pattern; serious corrections usually take place in the first or second year of presidential-terms, and the third and fourth year are almost always positive.

However, few may be aware of its more sinister sub-pattern, which is when a president is in his second term, as President Obama is, and there is not a correction in the first two years of that second term.

In an administration’s first term, a major goal is to be re-elected. Therefore, the pattern is that they prefer that any potential problems for the economy or stock market take place in the first or second year of the term, and do little to prevent it. They then pull out all the stops in the third and fourth year to make sure the economy and market are strong again when election time rolls around.

As Jeremy Grantham, CEO of international wealth management firm GMO says, “All markets tend to drop in the first two years of a presidential cycle. The key for people to remember is that whoever is president has astonishingly little effect, whereas the cycle itself, the desire for the incumbent party to get re-elected, is clear in the data. The precipitating factor is economic housecleaning by officials in Washington. Presidential Administrations want to correct imbalances in the economy in the first two years of their term, so they will have breathing room in year-three to stimulate the economy and set things up for the next election. An unintended consequence is that the stock market usually falls in the first two years of the cycle.”

However, an administration in its second term, unable to be re-elected again, seems to have less interest in the next election. They tend to try to keep the economy and market growing through the last two years of their first term, and then all the way through the four years of their second term.

It does not usually work out well, since it raises the risk of having the market become even more over-heated and over-valued in the third and fourth year of their second term.

For instance, the last three presidents to serve two terms were Reagan, Clinton, and Bush Jr. All three experienced corrections in the first or second year of their first term, and strong markets in the last two years.

However, after being re-elected, they did not allow a cooling off in the first two years of their second term, instead striving to keep the strong economy and market of the last two years of their first term, going for another four years, all the way to the end of their second term.

In all three cases, the result was not good.

The 1987 crash took place in the third year of Reagan’s second term. The 2000-2002 bear market began at the beginning of the fourth year of Clinton’s second term. The 2008 financial meltdown began in 2007, the third year of Bush Jr.’s second term.

So far, the Obama administration, in the second year of its second term, is seeing the same pattern.

Investors are hoping for no correction and a strong market in 2015 and 2016.

Given the high valuation levels, high levels of investor bullishness, the concerns of so many ‘smart money’ billionaires, the unusual length of time without even a normal 10% to 20% correction, there is high risk of a significant correction.

That might be the best scenario, since the risk is much higher for something worse later if a normal correction does not take place now.

Sy Harding publishes the financial website Street Smart Report Online and a free daily Internet blog at Sy’s Free Blog. In 1999 he authored Riding The Bear – How To Prosper In the Coming Bear Market. His latest book is Beat the Market the Easy Way! – Proven Seasonal Strategies Double Market’s Performance!

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